The Low Volatility Period Ends with a Thud

Never say never…we recently talked about the fact that many markets had become 'dull' indicating that a big move was imminent. Due to the fact that  discounts to NAV in closed-end bullion funds have recently contracted, we figured that gold was somewhat more likely to move up than down, but evidently it was not to be (as an aside to this: GTU's discount to NAV has expanded to 4.1% now, but that is still well below the 52 week high of 7.5%. In other words, a positive divergence remains in place in terms of this measure). The recent persistent weakness in gold stocks turned out to be the more relevant early warning sign. Here is a chart of spot gold showing the damage:

Gold breaks to the downside from a symmetrical triangle and closes below a lateral support level that has held since early April. The green line could potentially provide support as well, but that remains to be seen – click to enlarge.

The probability that this breakdown is 'genuine' is quite high – we'd rate it at least 70% if not more. Sometimes such breaks turn out to be 'false' (a recent example was copper's break below a multi-month support level in March, which was almost immediately reversed. The Australian and Canadian dollar also experienced false support breaks not too long ago). A 'false break' would be quite bullish, however, it is clear that this is usually the by far lower probability event.

One reason to believe that Tuesday's move likely implies that a test of the next major support level must be expected is that gold stocks have fully confirmed the breakdown. They have gapped below lateral support, while the HUI-gold ratio has concurrently fallen to a new low for the move. The only thing the sector has still going for it at the moment is that sentiment remains in the dumps – but that hasn't been very important in the context of short term trends for quite some time.

The HUI and the HUI-gold ratio both confirm gold's breakdown – click to enlarge.

A Small Positive Divergence

Is there anything positive to report? For one thing, treasury note and bond yields have resumed their recent decline, so the bond market continues to be skeptical about the US economic outlook.

Moreover, silver has actually diverged a bit from gold by failing to break through support so far. Below is a chart comparing the two metals and their respective lateral support levels:

A slight divergence between gold and silver relative to their lateral support levels was still in evidence as of Tuesday's close – click to enlarge.

As can be seen though, this is a very slight divergence and it won't take much to remove it (one more day of weakness would probably suffice). Still, it would be remiss of us not to point it out.

The only other evidence we have that may turn out to be constructive is that trading volume in GDXJ was close to a record high on Tuesday, and GDX volume, while not near a record, was quite chunky as well.

Incidentally, trading volume in gold futures was also quite high – there hasn't been such a busy day in many months, which indicates that the breakdown was fully embraced by traders (a lot of stops were evidently triggered and many have probably shorted the break as well). Whether it was high enough to indicate a 'selling climax' remains to be seen however.

Conclusion

It certainly looks as though the trend remains down in the short term (keep in mind that the summer months are usually also the seasonally weakest period in gold).  However, this is all still consistent with the idea that the market is in the process of putting in a long term bottom.

The types of divergences that are usually encountered in the context of longer term trend changes have already occurred last year. If the bottoming period is a mirror image of the topping period in 2011-2012, one should expect that it will take some time before a trend change becomes clearly evident. We are now about 11 months from the June 2013 low. In 2012, gold made a secondary high about one year after its 2011 peak. Both highs were likewise accompanied by  divergences with silver. However, the precious metals stocks need to regain relative strength, i.e., the HUI-gold ratio probably needs to turns up before a sustainable rally can develop. Very likely the eventual turning point (whenever it occurs) will be identifiable by another divergence between the metals and the mining stocks.

Charts by: stockcharts, barcharts